Mounting Woes Left Officials
With Little Room to Maneuver

By

Deborah Solomon,

Sudeep Reddy and

Susanne Craig

Updated Sept. 8, 2008 12:01 a.m. ET

WASHINGTON -- In the end, Fannie Mae and Freddie Mac had no choice.

Summoned to separate meetings on Friday with Treasury Secretary Henry Paulson and other top officials, the two mortgage giants were told they could either agree to a government takeover or one would be foisted upon them.

"We have the grounds to do this on an involuntary basis, and we will go that course if needed," Mr. Paulson told senior executives at the two companies, who had little idea such a move was coming, according to three people familiar with the meetings.

There was no dramatic trigger, nor was there fear of imminent collapse. Instead, the sweeping government intervention stemmed from a growing realization by Treasury and Federal Reserve officials that the two companies couldn't survive in their present forms, and that any collapse would be devastating to the economy.

The decision was hashed out over weeks of meetings. They included a conclave of Federal Reserve officials during their annual retreat at Jackson Hole, Wyo.; a mid-August polling of bond-market players by Morgan Stanley bankers advising Treasury; and a marathon session over the Labor Day weekend, fueled in part by Diet Coke and Coke Zero.

Dozens of bankers and lawyers were involved in the process. One junior banker joked that the round-the-clock schedule was tougher than prison -- at least there, you got three square meals a day.

In the end, Mr. Paulson, Federal Reserve Chairman Ben Bernanke and James Lockhart, head of the companies' regulator, the Federal Housing Finance Agency, concluded that the two companies had lost the confidence of the markets and couldn't survive as currently structured. No one could say how much money from the Treasury, either via a loan or an equity investment, would be enough to get them through the housing mess. Hence, the need for the government to step in and stabilize what has become a vital cog for the housing and mortgage market.

This account of the government's dramatic decision is based on interviews with government, Wall Street and company officials and others.

The Treasury's Hope

In July, Mr. Paulson received authority from Congress to prop up the companies through a loan or equity investment. Although he said he had no plans to intervene, he hired Morgan Stanley to review Fannie and Freddie's books and come up with ways to structure an investment, should one be needed.

Inside Treasury, the hope was that merely receiving authority to backstop the two companies would comfort markets enough that they could raise capital on their own. Both companies needed to replenish their capital, which had been eroded by billions of dollars in mortgage losses.

Mr. Paulson did not want to intervene, one government official said, in part because doing so would require a lengthy explanation to Congress. "We stood on the steps of Treasury and said we had no plans to use this authority," the official said. Going back to Congress would not be "an easy pivot."

Two things would soon force Treasury's hand. Uncertainty about Treasury's plans and how any intervention would affect shareholders caused shares of Fannie and Freddie to fall sharply, making it all but impossible for them to raise equity. At the same time, government bank supervisors and Morgan Stanley bankers studying the loans that are guaranteed and owned by Fannie and Freddie determined that the companies were facing serious capital shortfalls.

On Aug. 7, the lead bankers on the Morgan Stanley team, Robert Scully and Ruth Porat, met with Mr. Paulson for the first time. Mr. Paulson told them nothing was off the table in terms of structuring an intervention.

Inside Treasury, the working theory was that if they had to intervene, an equity investment would be the most likely course. Mr. Paulson and his staff debated the impact on shareholders. If they made an investment, Mr. Paulson told his staff, he did not want it to benefit shareholders. He didn't want the government to be seen as bailing out investors who profited from the companies' hybrid status as private entities that have the implicit backing of the government.

Morgan Stanley, which had about 40 bankers working on the matter, broke into teams. They provided ongoing updates to Mr. Paulson, often meeting with him as early as 7 a.m. or as late as 11 p.m.

Morgan Stanley started soliciting outside input. During a conference call in mid-August -- one in a series -- bond-market investors with known positions in Fannie and Freddie debt were invited to give their views. Morgan Stanley bankers participated in listen-only mode so no one could interpret their reactions. Minutes of the meeting were distributed to other Treasury officials.

Financial institutions, investors and other market participants were painting a grim picture: Investors weren't going to invest more in the company unless Treasury kicked in some money, or made clear what would happen to those who did pony up funds.

Treasury asked how much money it would need to inject. It soon became clear that no amount was going to be enough. If Treasury were to inject $10 billion, the market would want to see $20 billion. If Treasury put forth $20 billion, the market would want $30 billion.

At Fannie Mae and Freddie Mac, executives were painting a much rosier picture. They insisted they could raise capital if Treasury would step in and provide some kind of support. Fannie Mae proposed that the government guarantee that new investors would be protected if the government later intervened -- a move Fannie thought would help it raise money.

After shaking up his top management team, Fannie Chief Executive Officer Daniel Mudd wrote in a memo to employees: "Now it is time to pull on our boots and march out of this mess."

Three Options

On the morning of Aug. 18, the Morgan Stanley team presented its preliminary findings to Treasury officials. The meeting, held in Mr. Paulson's conference room overlooking a courtyard, lasted the entire day. About 30 people participated.

The upshot: The companies were facing a deep financial hole. While their capital might meet the letter of regulatory requirements, they still might not have enough to cover their expected losses. Morgan Stanley bankers scoured the books on the loans guaranteed and owned by Fannie and Freddie. Using assessments about what would happen to the housing market over the next 18 months, they determined that the companies were in need of as much as $50 billion.

At that point, Mr. Paulson and his staff began to realize an equity investment might not work. The companies needed so much capital that if Treasury were to go in, it would have to structure the investment on generous terms to gain shareholder approval, something Mr. Paulson did not want to do.

Morgan Stanley presented three options to Treasury: receivership; a less aggressive option called conservatorship, in which the companies' regulator, the FHFA, would essentially run the companies' operations; and the even more incremental step of having the companies try to raise money on their own.

In late August, during the Fed retreat in Jackson Hole, top central-bank officials from Washington and New York slipped out of conference sessions and met for several hours in a lodge conference room to discuss options. Mr. Paulson had asked the Fed in July for its expertise, and its bank supervisors had begun poring over the firms' finances. Fed officials had been warning about the firms for a decade.

Fannie and Freddie were still able to fund themselves, but it was getting more expensive to do so. Foreign officials, whose central banks own Fannie and Freddie debt, were calling Mr. Paulson to express concern.

Sen. Charles Schumer, a New York Democrat, said he was told by government officials that foreign investors were threatening to bail out. "There was a real fear that foreign governments would start dumping Fannie and Freddie...and not buy the bonds," he said.

Once Treasury realized conservatorship was a possibility, it assembled a transition team to work with the FHFA on how such a takeover would work. The team -- led by Jim Wilkinson, Treasury's chief of staff, and Edward DeMarco, FHFA's chief operating officer -- reviewed how to ensure that the companies could continue to operate and how to keep employees from leaving, among other things.

The big decision came together during a marathon series of meetings over Labor Day weekend at Treasury's offices. A dozen Treasury officials, including Mr. Paulson, gathered together with Mr. Bernanke, Fed Governor Kevin Warsh, the Fed general counsel and a top banking official and Mr. Lockhart's team.

The group gathered in a conference room across from Mr. Paulson's office at 8:30 a.m. that Saturday. They were dressed mostly in business-casual khakis and shirts. They began discussing their overarching principles, and evaluating the pros and cons of each option.

They recognized they only had bad alternatives, but agreed that the risks of doing nothing were too great. By late Saturday, they were leaning toward conservatorship as the best option. They spent the next two days thinking through legal and market implications. Mr. Paulson led the sessions. Mr. Bernanke and other top officials weighed in.

More Analysis

Treasury planned to tell the two companies about the plan last Friday, and complete it by Sunday, in time for the opening of Asian markets. Mr. Paulson needed one more thing: He later pressed for Mr. Bernanke to issue a statement of support.

Mr. Lockhart, however, wanted more analysis. Without his approval, the takeover would not happen. After looking at data assembled by the Fed, the Office of Comptroller of the Currency and FHFA, Mr. Lockhart agreed that the companies were in a severe capital hole.

On Friday, Mr. Mudd, Fannie's CEO, and Richard Syron, Freddie Mac's chief executive, were summoned to FHFA's offices in Washington for separate meetings. Messrs. Lockhart, Paulson and Bernanke sat on one side of the conference room table. Company executives sat on the other side.

Mr. Lockhart spoke first, telling the firms that they were going to be taken over. Mr. Paulson then told the executives they could go along willingly, or FHFA would declare them undercapitalized and take them over involuntarily.

Mr. Paulson raised concerns about the companies' capital positions. The companies needed to take more reserves to cover mortgage-related losses, but doing so might have put them in violation of the standards that govern them.

Mr. Syron was taken aback, according to two people familiar with his thinking. While the companies had expected Treasury to take some action, he didn't expect this. As of Tuesday, the Freddie board still had been whittling down the list of possible candidates for the CEO job, and was exploring other ways to raise capital on its own, according to one person familiar with the matter.

Mr. Mudd said he would have to take the issue to his board, which he did the next day.

Mr. Syron called a board meeting immediately after his FHFA meeting. "Paulson said, 'Accept or it will happen,'" Mr. Syron told the board, according to a person familiar with the matter.

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